Employee Misclassification: A Risky Business For Employers

The practice of employee misclassification, typically involving the misclassification of employees as independent contractors, is a problem prevalent in many industries - especially the construction industry - and has recently received growing attention from state legislatures. Employers should be increasingly concerned as numerous states, including New York, New Jersey, Massachusetts and Illinois, have stepped up their enforcement efforts against the misclassification of workers.

The Misclassification Problem

The stakes are high for all who are involved. For the federal government and the states, misclassification translates into millions and even billions of dollars in lost tax revenues. On the federal level, the U.S. Government Accountability Office estimates the loss in 2006 alone at $2.72 billion in federal Social Security, unemployment and income taxes. According to a study conducted by the University of Missouri-Kansas City, from 2001 to 2005, the state of Illinois lost an estimated $124.7 million in income tax annually - $8.9 million of it in the construction sector.1 Other state studies have reported similar losses attributable to misclassification.

In addition to lost tax revenues, misclassified employees themselves are negatively impacted. Misclassification denies such workers federal and state legal protections, such as coverage under employee protection laws, as well as employer-provided benefits to which they might otherwise be entitled, not to mention the possibility of not receiving proper wages from employers. And for employers, misclassification presents a serious risk of liability for back taxes, overtime pay and employee benefits as well as attorneys' fees, costs and penalties associated with claims brought by employees or federal/state agencies.

Typically, misclassification occurs at the hiring stage, when newly hired workers are categorized as either employees or independent contractors. While some employers may intentionally misclassify in an attempt to reduce labor costs and gain an unfair advantage over competitors, most employers unintentionally misclassify workers simply because employers are confused or unclear about the standards used to classify workers. Such confusion or lack of clarity is understandable, as there is no definitive test available to make this determination. Rather, various laws, such as the National Labor Relations Act, the Fair Labor Standards Act and the Employee Retirement Income Security Act, all define the term "employee" differently and use various tests to distinguish between independent contractors and employees. Further, different state and federal laws, agencies and courts have developed their own tests or listings of factors.

The most comprehensive list of factors that an employer may take into account when determining how to classify workers is the one used by the Internal Revenue Service (IRS). The IRS factors, derived from the common law "right to control" test, examine a variety of factors grouped under the rubric of behavioral control factors (such as whether the worker or the company controls the specific methods, hours or manner of how and when work is performed), financial control factors (such as the timing of wages and the provision of work tools and equipment) and factors concerning the relationship between the worker and the company (such as the availability of benefits and whether the worker provides services for multiple employers). A key element in the IRS test, as well as in other statutes, is the degree of control exercised by an employer over a worker. In essence, employees take direction from employers for the means, methods and hours of work, whereas independent contractors are in business for themselves and retain the right to determine how to accomplish the tasks they have been hired to perform. However, these factors and the analysis used by courts to make an employee/independent contractor determination are very fact specific.

State Initiatives And Potential Federal Legislation

A recent Cornell University study, which focused on the misclassification of workers in New York state, found that approximately 10 percent of the state's workers were misclassified.2 The report found that the construction industry, which alone comprised 15 percent of all misclassified workers, was a particular problem because it is highly competitive and labor intensive, has a volatile and seasonal work flow and workforce and is a source of employment for illegal or undocumented workers.

Studies in other states have found similar results. A Massachusetts study found that between 2001 and 2003, approximately 9 percent of Massachusetts workers were misclassified, including 11.4 percent in the construction industry.3 Interestingly, this report found that several other industries, including education/health services, professional/business services and transportation/utilities, had even higher rates of misclassification. The Illinois study mentioned earlier also found that the percentage of misclassified employees in the state increased nearly 55 percent between 2001 and 2005.

The Cornell University study motivated Governor Eliot Spitzer to create a Joint Enforcement Task Force on Worker Misclassification in September 2007. This Task Force aims to audit employers and investigate potential worker misclassification. Employers that misclassify may be assessed penalties, higher tax assessments and periodic audits. On February 11, 2008, the New York Department of Labor announced that through December 2007, the Task Force conducted 15 audits focusing on the restaurant and construction industries and found more than $19 million in unreported wages, approximately $3 million in minimum and overtime wages owed to workers and assessed more than $1.2 million in taxes and penalties to noncompliant employers. With the "success" of the Task Force's efforts in just its first four months of existence, New York employers should expect continued and increased state enforcement.

In New Jersey, Governor Jon Corzine announced in 2007 that the Department of Labor and Workforce Development (LWD) and Department of Treasury have joined forces in an attempt to eliminate worker misclassification in the state. As part of these Departments' joint efforts, an employer that is now found to have misclassified employees will face penalties from the LWD as well as the New Jersey Department of Taxation, which will receive the results of any LWD employer audits.

Beyond state executive enforcement actions, several state legislature have passed laws that create a rebuttable presumption in favor of an employer-employee relationship and place the burden of proving otherwise on the employer. In New Jersey, the Construction Industry Independent Contractor Act (CIICA), which was passed in July 2007, creates such a presumption for full-time construction workers for purposes of various New Jersey labor and employment-related laws. Under the CIICA, in order to properly classify a worker as an independent contractor in the construction industry, the employer must now prove that the worker: (1) has been and will continue to be free from control or direction over the performance of his/her services; (2) the service provided by the worker is either outside of the employer's usual course of business or is performed outside of the employer's places of business; and (3) the worker is customarily engaged in an independently established trade, occupation, profession or business.

Other states have made similar efforts. Legislation similar to New Jersey's CIICA have been enacted in Massachusetts and New Mexico. As recently as January 1, 2008, Illinois' Employee Classification Act, also aimed at the construction industry, went into effect. Many of these statutes create civil penalties, punitive damages and criminal penalties for willful violators and allow aggrieved workers to collect wages, salary or benefits lost and, under certain circumstances, liquated damages, compensatory damages and attorneys' fees, as a result of the misclassification.

Spurred on by these state initiatives, federal lawmakers are also getting involved. Last year, the Independent Contractor Proper Classification Act of 2007 (ICPCA) was introduced in the U.S. Senate and seeks to establish a detailed enforcement scheme shared by several federal administrative agencies including the IRS and the DOL. The ICPCA, like various state laws, also seeks to place additional responsibilities on employers. As proposed, the ICPCA would require employers to notify any potential independent contractors of their federal tax obligations, the legal protections that are inapplicable to them and their right to seek a status determination from the IRS. While not likely to be enacted in 2008, the ICPCA is likely to gain additional support as increased state regulation puts additional pressure on Congress to act.

The Bottom Line: Some Advice For Employers

Employers should familiarize themselves with state and federal laws that govern worker classification and take care to correctly classify workers, as the liability for not doing so may be significant. Employers that misclassify their workers may be held liable for back taxes, wages and unemployment and workers' compensation contributions.

The degree of control that an employer has over its workers will often determine whether an employer-employee relationship exists. The more control an employer has, the more likely it is that the worker is an employee rather than an independent contractor.

Keep in mind that certain actions are inconsistent with classifying workers as independent contractors. For example, independent contractors are not employees and should not have supervisory responsibilities, receive employee handbooks or undergo performance evaluations.

While not determinative, independent contractor agreements may minimize employer liability. When drafting such agreements, employers should be mindful of the factors used by the IRS (or other federal agencies) and their state courts and incorporate those factors into the agreements.

1 The Economic Cost of Employee Misclassification in the State of Illinois, Michael P. Kelsay, et. al., University of Missouri-Kansas City, December 2006.

2 The Cost of Worker Misclassification in New York State, Linda H. Donahue, et. al., Cornell University, February 2007.

3 The Social and Economic Costs of Employee Misclassification in Construction, Franoise Carr, et. al., Harvard Law School, December 2004.

Vjera V. Silbert is an associate in WolfBlock's Employment Services Practice Group. She provides counseling on a variety of employment issues including affirmative action programs and the immigration process as well as on the intersection of employment practices and immigration issues. Marc J. Scheiner is an associate in WolfBlock's Employment Services Practice Group. He provides counseling on a variety of employment issues, represents clients in employment litigation matters and conducts trainings for managers on a range of workplace topics.